Employee Stock Options: Financing Constraints Explanation

Abstract

Prior literature suggests three explanations for granting stock options as a form of compensation to non-executive employees. Broad-based option grants can be used as an incentives tool, a sorting mechanism, and a means of assisting with employee retention. An alternative explanation is that financially constrained firms use broad-based option grants as a form of self-financing. Using empirical data on broad-based option grants, a financial constraints index and individual variable proxies for financial constraints, we examine the relationship between option grants and the severity of financial constraints to which the firm is subject. We find that direct financial benefits to the firm from the use of option grants are possible. However, sorting is more likely reason for using broad-based option grants, while self-financing is a positive side effect of sorting.